The Relationship Between Options Trading Volume and Stock Price Movements

by: Paul Kedrosky

While option traders often get a bad rap as risk-seeking crazies with the attention span of Mary Hart, a paper summarized in yesterday's Times shows how an option piggy-back strategy turns in impressive numbers.mary hart Assuming you have the size and can therefore deal with high portfolio turnover, a naive volume-following option strategy turned in 50% annualized returns over the last fifteen years:

We present strong evidence that option trading volume contains information about future stock price movements. Taking advantage of a unique dataset from the Chicago Board Options Exchange, we construct put-call ratios from option volume initiated by buyers to open new positions. On a risk-adjusted basis, stocks with low put-call ratios outperform stocks with high put-call ratios by more than 40 basis points on the next day and more than 1% over the next week. Partitioning our option signals into components that are publicly and non-publicly observable, we find that the economic source of this predictability is non-public information possessed by option traders rather than market inefficiency. We also find greater predictability from option signals for stocks with higher concentrations of informed traders and from option contracts with greater leverage.